There is a basic presumption in the tax Code that any
accession to “wealth” is income. It isn’t much of a leap for the tax Code to
then say that all income is taxable unless otherwise excluded.
Let’s next look at “wealth.” I propose a working
definition as follows:
Assets
(A) = Liabilities (L) + Wealth (W)
A little algebra shows the following:
A – L =
W
Here is spiff on the above: do you have wealth if your
liabilities go down?
Let’s look at the Katrina White case.
Katrina started a business in 2015. She took out a
business loan for $15,000. She leased space for her business, signing a three-year
lease.
The business did not work out. The family lent her $8
grand, but there was no way to save it. She had repaid the bank less than a
grand when her remaining debt of $14,433 was discharged. The bank sent her a
1099, of course, as all American life events can apparently be reduced to a
1099.
Katrina never made a payment on the lease. Since rent
was late for more than two months, the entire lease became due and payable.
That fiasco totaled $21,700.
She filed her
return.
The IRS said she left out income of $14,433.
How?
Let’s go through it.
Katrina said that her wealth (that is, A – L = W) was
as follows when the business failed:
Real property |
28,500 |
|
Personal property |
3,560 |
|
32,060 |
||
Student loans |
5,294 |
|
Utilities |
961 |
|
Utilities, estimated |
2,500 |
|
Furniture loan |
1,120 |
|
Judgements |
8,128 |
|
Bank loan |
14,433 |
|
Lease breach |
21,700 |
|
Family loan |
7,800 |
|
61,936 |
||
Net wealth |
(29,876) |
The IRS wasn’t buying this. They argued that:
· The
estimated utilities were a no go.
· The
family loan wasn’t really a “loan.”
· While
we are at it, the lease breach wasn’t really a loan, as the landlord had no intention
of enforcing the debt.
The IRS math was as follows:
Real property |
28,500 |
|
Personal property |
3,560 |
|
32,060 |
||
Student loans |
5,294 |
|
Utilities |
961 |
|
Furniture loan |
1,120 |
|
Judgements |
8,128 |
|
Bank loan |
14,433 |
|
29,936 |
||
Net wealth |
2,124 |
The matter went to Tax Court.
The Court pointed out the obvious: Katrina signed a
valid and binding lease contract. Perhaps the landlord decided that there was nothing
there to pursue, but it cannot be argued that she had an enforceable debt.
The Court saw the following:
Real property |
28,500 |
|
Personal property |
3,560 |
|
32,060 |
||
Student loans |
5,294 |
|
Utilities |
961 |
|
Furniture loan |
1,120 |
|
Judgements |
8,128 |
|
Bank loan |
14,433 |
|
Lease breach |
21,700 |
|
51,636 |
||
Net wealth |
(19,576) |
Let’s recap our numbers:
Wealth per Katrina was ($29,876)
Wealth per the IRS was
$2,124
Wealth per the Court was ($19,576)
Remember what we said at the beginning, that all
income is taxable unless there is an exception? Well, there is an exception for cancellation
of debt. Several, in fact, but today we are concerned with only one:
insolvency. The Code says that one does not have income to the extent that one
is insolvent.
What is insolvency?
Go back to the formula: A – L = W.
To the extent that “W” is negative, one is insolvent.
Another way of saying it is that one has more debts than assets.
So, who showed negative “W”?
Well, Katrina did. So did the Court.
Katrina was insolvent. That was an exception to cancellation
of indebtedness income. Katrina did not have taxable income. The IRS lost.
Our case this time was Katrina White v Commissioner,
T.C. Memo 2023.-77.
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